Mergers and acquisitions basics: why deals create or destroy value, synergies, integration

Buying another business can be the fastest way to grow, add skills or enter a market. It is also one of the easiest ways to lose money. The same few mistakes appear again and again: expecting too much from the combination, paying too much for it, and underestimating the work of putting two businesses together.

This guide explains how acquisitions create or destroy value, how to think about synergies and price, what integration involves, and a simple process for a smaller business considering its first deal.

Why so many deals disappoint

A 2011 Harvard Business Review article noted that “study after study puts the failure rate of mergers and acquisitions somewhere between 70% and 90%”. Exact figures depend on how failure is measured, but the direction is consistent.

McKinsey’s analysis in Where mergers go wrong gives the main reason: buyers usually overestimate synergies, and so overpay. With several bidders, the winner is often the one with the most optimistic estimate, a pattern known as the winner’s curse. The authors found that buyers often hand sellers nearly all the value a deal creates, through premiums of 10 to 35 percent over the target’s market value before the deal is announced.

How a deal creates value

A simple test sits behind every acquisition:

Value created for the buyer = value of improvements (synergies) minus the premium paid minus the one-time costs of integration.

If the premium and costs are larger than the improvements, the buyer’s owners lose, even if the combined business is bigger. McKinsey’s article on the six types of successful acquisitions says that even a deal with a sound logic “won’t create value if you overpay”. It describes six types of deal that tend to create value:

1. Improving the target’s performance, for example by cutting costs or speeding up growth.
2. Removing excess capacity from an industry.
3. Giving a product faster access to market through a bigger company’s sales and distribution.
4. Buying skills or technology faster or more cheaply than building them.
5. Exploiting scale advantages specific to the industry.
6. Picking winners early, before an industry’s growth is widely recognised.

McKinsey also notes that “each deal must have its own strategic logic”. Vague reasons such as “growth” or “strategic positioning” are linked to less successful deals.

Synergies: cost, revenue and dis-synergies

Synergies are the gains from combining two businesses that neither would achieve alone. McKinsey’s study of 160 mergers found clear differences between types:

• Cost synergies (shared offices, combined purchasing, fewer duplicate roles) are more reliable. About 60 percent of deals delivered planned cost savings almost in full. In about a quarter, though, cost synergies were overestimated by at least 25 percent.
• Revenue synergies (cross-selling, wider distribution) are the biggest source of error. Almost 70 percent of mergers failed to achieve the revenue synergies expected.
• Dis-synergies are often ignored. The typical merging company lost 2 to 5 percent of its combined customers, and some lost more than 30 percent, as customers left during the disruption.

The practical lesson: count cost synergies carefully, give revenue synergies a heavy discount, and include an explicit estimate for customers and staff you may lose.

Paying the right price

McKinsey reports that the average premium paid has been almost 30 percent of the target’s share price before announcement. That premium has to be earned back through improvements before the buyer gains anything. Bargains do happen, for example at the bottom of an economic cycle, but they are rare.

Price discipline means setting a walk-away price before negotiations start, based on what synergies you can realistically deliver, and sticking to it. McKinsey warns of hubris here: management teams often overstate their ability to improve a business they have not yet run.

Integration: where value is won or lost

Synergies only exist on paper until the businesses are combined. McKinsey found that deal teams often underestimate one-time integration costs. In one example, a chemical company committed to annual savings of 210 million dollars at a one-time cost of 250 million; comparable deals suggested the cost would be at least 450 million, and the company went over budget and missed its targets.

Good integration planning starts before the deal closes. Decide what to combine and what to leave alone. The HBR article argues that buyers need to understand “whether and how to integrate” a target, because absorbing a business can destroy what made it valuable, especially when you are buying a different business model. Name an integration leader, set out the first 100 days, protect key customers and staff, and track synergies against plan every month.

A process for a first acquisition

1. Write the logic. In one sentence, state which of the six value-creating types the deal fits and why.
2. Value the target on its own. What is it worth with no changes?
3. Estimate synergies line by line, with an owner, timing and the evidence behind each.
4. Estimate integration costs and dis-synergies, and add a margin for error.
5. Set a walk-away price that leaves value for your side after premium and costs.
6. Carry out due diligence, with accountants and lawyers checking finances, contracts, tax and liabilities.
7. Plan integration before signing, including communication to staff and customers on day one.

A worked illustration and common mistakes

An example (illustration only). A UK marketing agency considers buying a smaller agency worth 2.0 million pounds on its own. The seller wants 2.6 million, a 30 percent premium. The buyer’s team estimates synergies with a present value of 0.9 million: 0.5 million from shared offices and software, and 0.4 million from cross-selling. Integration will cost about 0.3 million.

On these figures, value created is 0.9 minus 0.6 (the premium) minus 0.3, which comes to zero. If the cross-selling falls short, as revenue synergies often do, and the firm loses a key client, the deal destroys value. The buyer offers 2.2 million or walks away.

The most common mistakes follow the same pattern:

• Paying for revenue synergies that may never arrive.
• Ignoring customer and staff losses during the transition.
• Letting the excitement of the deal override the walk-away price.
• Leaving integration planning until after completion.
• Forgetting competition rules. In the UK, notifying the Competition and Markets Authority is voluntary, but the CMA’s guidance says it can still investigate a completed merger that meets its legal criteria. Check the rules in each country where the businesses operate, and take professional advice.

Acquisitions are worth considering when there is a specific reason the combination will perform better than the two businesses apart, and a price that leaves you room to capture that gain. Without both, organic growth or a partnership is usually the safer route.